Master Your Finances: All You Need to Eliminate Debt and Increase Savings

1 Money, Wealth, and Personal Finance

Mastering your personal finances isn’t just about cashing checks, paying bills, and meeting your monthly obligations. It is about accumulating enough wealth to achieve family goals and aspirations through the application of sound financial principles and behavior.

It’s a Question of Money

According to the Bible, money answereth all things and the love of money is the root of all evil. And, as the Beatles put it, money can’t buy you love. So what is money? What does it mean to us? Is it good or evil? Does it give us happiness or misery? Is it something we should strive for or a goal in itself?

Regardless of your personal feelings and approach to money, at the very least you could hardly question that it is a means to an end. Unless you are able to build your own house, farm your own food, and make your own clothes, money is the vehicle to basic sustenance. Beyond that, we can all agree that money helps to achieve education, allow you to travel, and give you the ability to spend time doing things other than work. That is, money can make your life better and easier. And that’s what personal finance is all about—managing money with an end in mind of achieving goals, while avoiding the problems that arise when there isn’t enough money.

Money Is Not Wealth

In economics, money is just a commodity. This may sound kind of strange—as if money could be traded around in bushels, barrels, or boxes; stored in silos and warehouses; or sold in lots and shipped in rail cars to the highest bidder. Well, that’s actually true—though in a figurative, not a literal, sense. Money is stuff just like the stuff we buy with it. We use it to receive the value of what we produce (by working, selling, or investing) and to transfer that value to something else (food, transportation, clothing, shelter, or pleasure) that we need or want. Having money, by itself, doesn’t really mean anything about wealth; as we know, you can have money in your pocket but owe $3,000 on your credit card bill.

Take Charge of Your Personal Finances

There is a reason why you spent your hard-earned money for this book. Perhaps your finances are out of control, and you find there is always too much month at the end of your money. You want to get a rope around your current finances, to stay afloat month to month, and to be prepared for those unexpected expenses—when your car breaks down or when you get those insurance bills (which shouldn’t be unexpected anyway). Or perhaps you are in decent financial shape, financially fit as it were, and you want to fine-tune your finances and build wealth towards achieving some aspirational goals. The following are the most common personal finance issues:

Overspending: Almost everyone succumbs to the temptation to overspend at one time or another, but chronic overspending is a serious problem. Debts pile up quickly and form a barrier to achieving other financial and personal goals.

Surprises: Failing to plan in advance can give you an unpleasant surprise as you suddenly find yourself struggling to pay those surprise insurance and utility bills at the end of the month. Remember: Lack of awareness creates overspending—and debt.

Procrastination: People tend to put things off, particularly for long-term goals and needs. Saving for retirement or college is more effective if you start earlier rather than later, even if you start in small increments.

Using emotion, not reason: Allowing your emotions to cloud your mind can result in poor financial decision-making. Deals that look too good to be true usually are. Four-day weekends are fun and necessary at times, but are they really worth a thousand dollars? Reason must accompany emotions and feelings.

Financial personality clashes: What do you do if you are a spender and your spouse is a saver? You build a workable financial plan that relies on each person’s strengths to carry it out.

Whatever your issues, this book will help you solve them and to develop a personal finance system combining tools and techniques with habits and behavior to achieve your objectives.

Knowing What You’re up Against

To begin, you need to have a good working definition of what personal finance is. The objective of managing your finances is to reach your and your family’s goals, in terms of both keeping what you have and obtaining what you want. When it comes to personal finances, your family is in charge—each family member is both the manager and the beneficiary. What does this mean? In a business situation, the managers and the beneficiaries (shareholders) are different parties. Managers manage business finance with the aim of achieving shareholder wealth. In government, officials manage finances for the benefit of the public. In the case of personal finance, you manage your own finances for your own benefit. Nobody does it for you. The process works better if everybody in the entity participates in this assignment. This means someone will have to take charge as a leader.

If you are in debt, you obviously have some work to do before you start accumulating wealth. Still, wealth should be the real objective of any personal finance-savvy individual or family. Active personal finance sets a mark, or goal, then provides the tools, techniques, and behaviors to reach that goal.

Tools and Rules—And Beyond

Personal finance uses a system of tools and techniques to achieve financial reward. You are undoubtedly already familiar with many of them—banking, investments, insurance, and retirement plans. Information describing these tools and how they work is widely available. However, successful personal finance means being able to put all the tools together to build a solid financial plan. Successful personal finance also means having the right attitude and discipline in daily life to carry out your plan. Tools without a plan won’t work, and a plan without execution won’t work either.

A Few Basic Principles

What is personal finance as a subject of study? A lengthy compendium of numbers, laws, and planning tools, tricks, and techniques? Yes—for the professional practitioner. This book, however, is not intended to prepare you for personal finance as a profession. It is intended to prepare you for personal finance in life. Three principles form the basic thread of personal finance:

1. Money, income, and wealth aren’t the same. Personal finance isn’t just about money or how much you make—it’s about how much you keep. Personal finance is concerned with wealth and the accumulation, preservation, and distribution of that wealth.

2. Personal finance isn’t just about the tools—it’s about behavior. Again, it requires the right set of behaviors to make the tools and techniques work.

3. Personal finance is a full-time job. Personal finance is more than just sitting down once a month to pay bills. You must be aware of your responsibilities all the time—otherwise all that you strive for can be wrecked in an instant.

Wealth and Financial Aspirations

Accumulating wealth means accumulating money beyond the obligations against that money. That is, wealth is having something left over after you pay all your bills and cover all your expenses. You will need this some-thing left over to conquer long-term obligations, like your children’s college education or your retirement plan. Beyond that, wealth can provide for your aspirations—goals wrapped around things you want, whether it’s a bigger house, a nicer car, a better retirement, or starting a business.

But Isn’t Income Important?

No common financial scenario can succeed without it. But it’s surprising how much income is overemphasized. Let’s say that I ask, How are you doing, money-wise? Ninety percent of the time, the answer sounds something like: I just got a raise, and now I’m making $80,000 a year. Okay, that sounds like a plausible answer.

But did it answer the question? Does the fact that you make $80,000 a year really tell me anything? What if you’re spending $90,000? What if you have $20,000 in personal debt and a negative net worth? What if you have three kids, aged four years apart, the first of whom is about to start college next year? Income is a great thing, and if you can get more of it, so much the better, but it cannot serve as an indication of your financial health.

Most people can’t control income on a day-to-day basis, but they can control their expenses. Accumulating wealth has as much (or more!) to do with how much you let out as how much you put in.

Your net worth is your assets (what you have) minus liabilities (what you owe or spend). Net worth is a bottom-line measure of wealth. Think of it this way: Money is accumulated into wealth, wealth achieves goals, net worth measures wealth. Do you know what your net worth is?

At the end of the day, personal finance is about strategies to accumulate, preserve, and distribute wealth. Accumulating wealth means putting in more than you take out and growing what you have through sound financial management and investing. Preserving wealth means controlling the outflow but also protecting your financial base. Finally, distributing wealth means managing the outflow towards achieving objectives—spending to meet goals.

A Brief Tour Through the Toolbox

If you think personal finance involves more than balancing the checkbook and trading stock online, you’re right. Conceptually, it’s the planned application of tools and behavior toward a goal of accumulating, preserving, and distributing wealth. Let’s look at a short list of some of the specific tools and strategies you will encounter as you manage your finances:

Budgeting and spending: Budgeting is a short-term plan for managing financial flows. Closely related is spending. You ask: is spending a financial tool? Not really—but as already pointed out, the effective management of spending is critical.

Banking and credit: These are tools to manage finances on a day-to-day basis; they may be used in wealth accumulation, preservation, and distribution. To use these tools effectively, you need to be aware that the banking system can work for or against you.

Investing: Investing is the other half of the accumulation game. Growing your accumulated wealth through productive investments augments your income contributions; investing may consist of in-tangible (securities) and real (property and collectibles) investments.

Insurance and risk management: Insurance and risk management are preservation techniques. Once you have assets and income, you need to preserve and protect them from certain types of risk. Loss of income and assets resulting from death, disability, and casualty (fire, theft, and so forth) are some of the major areas of risk, and insurance products are a major—but not the only way—to manage these risks.

Contingency planning: Aside from random, insurable events, personal life events can devastate finances. If you get laid off or have to care for a sick parent, what will you do? Minimize risks in advance, and have a ready plan to combat any problems you might face.

College and retirement planning: There are several tools to help you accumulate the funds to send your kids to college and to prepare a retirement plan to meet financial needs in old age.

Estate planning: The wealth that you do not consume in your lifetime will be left to others. It’s important to know how to do this according to your wishes, providing for the needs of your heirs without paying too much in inheritance and gift taxes.

Good financial planning involves a combination of these tools, depending on your particular situation and the phases of life. In the earlier stages of life, accumulation is more important; as we get older, distribution comes more into play.

To borrow from Lincoln, you won’t use all of the tools all of the time, but you can use some of the tools all of the time and all of the tools some of the time. It isn’t just about the tools—they won’t work without some cooperation from you.

On Your Best Behavior

Financial principles, tools, and techniques won’t work by themselves. Sure, they can help produce and preserve wealth, but no tool can work effectively if you aren’t in charge. Good personal finance blends tools and techniques with attitude and behavior. Managing something implies watching it and controlling it when necessary. Awareness and control are part of what we call the financial persona, or conscience, the part of you that watches everything and keeps it in order.

A Financial What?

Financial persona—sounds funny, doesn’t it? Like it might refer to greedy money people who prefer an in-depth reading of the stock page of the newspaper to a dinner with a best friend, those folks who think about money all the time. Fortunately, that’s really not the case. The financial persona is a personality and a lifestyle, a set of attitudes and behaviors essential to achieving your financial goals and financial success.

Avoiding injury in driving or in sports is as much a function of behavior and mindset as it is a function of devices and rules. The same approach should be applied to personal finance. There are dozens of excellent financial devices and rules that can help lead you to personal financial success, but they can’t work if you don’t develop the right mindset to go with them.

Next, let’s review some of the characteristics of an effective financial persona:

Awareness: You need to be aware of your current financial situation at all times. Somewhere in the back of your mind you should have a good notion of your net worth, debts, this month’s expenses, current credit card balances, and income you can count on receiving. You don’t have to write everything down, of course, and there is no need to keep a mileage log of all your minor purchases. However, you should be organized enough to know where to get that information if you do need it. A business CFO doesn’t know the dollars and cents of every asset or income account in the business, but he or she could give you the highlights in an instant; in the same way, you should be aware of the highlights of your financial situation.

Control: You should be able to control your expenses and financial transactions. If you buy that new shirt on sale, will you exceed the monthly personal allowance you have set for yourself? Maybe it’s a good idea anyway, because you need a shirt and the price is 50 percent off. Eventually, you will begin to realize that without awareness there’s no control, and without control, awareness doesn’t help, either.

Commitment: Commitment is the combination of diligence and persistence needed to get in control and stay there. Plans fail when you or your family members are only committed some of the time to achieving some of the results. Commitment implies agreement, follow-through, and rewards—when things go right.

Risk tolerance: Everybody has a different tolerance for risk. While it always makes sense to keep some wealth in reserve to meet unexpected or unplanned contingencies, some people will naturally want a bigger cushion than others. This has to do with each individual’s comfort level, security, and, to some extent, outlook on life. If you are one of those If something can go wrong, it will people, it’s hard to change that notion—it’s easier to create a financial reserve accordingly.

Your financial habits are the outward signs of an effective financial persona. Keeping track and occasionally checking your savings, investments, and net worth balances is a good habit. Keeping mental notes of money spent during the month and especially charges to credit cards is another. Holding off big purchases until funds are accumulated—or at least until budget impact is understood—is still another. Good financial habits are good management skills that include being aware, being in control, working with the people involved to achieve desired outcomes, making rational decisions, and adjusting to change.

The Persona Is Individual

You can’t delegate a financial persona, although many tasks can be delegated to other family members. Awareness, commitment, and control can’t be delegated.

It won’t work if one family member practices awareness and control, and the other spends freely. Everyone in the family unit must have and use a well-grounded financial persona, even though a single family mem-ber may take on the task of determining the budget, paying the bills, and monitoring wealth. Each family member must exercise the persona, and agreement among all on the details—goals, strategies, and objectives—is required so that the persona can work effectively in tandem.

It’s a Full-Time Job

Once you adopt your financial persona, you must adhere to it at all times. It just won’t work if you leave it behind when you drive off to the mall. It should be present in back of mind for all financial decisions.

Your financial persona manifests itself as a set of financial habits. It can help you counteract the impulses and emotions of a moment and keep an eye on such important things as how much you’ve charged so far that month, whether you’ve paid the day-care bill yet, and how you would handle that $500 car repair, should your transmission break down tomorrow. An active financial persona takes stewardship of your finances, almost on an up-to-the-minute basis. Ultimately, this stewardship is necessary to keep your plan from disintegrating, as well as to keep your wealth-creation in progress.

Like Any Job, You Must Learn It

As you set out to bring good personal finance into your life, don’t get overwhelmed by the size and complexity of the task. As long as you devote attention to it, you will have no problems achieving a financially productive lifestyle. Start simple, and you will grow. Sooner or later, the things that took a lot of effort in the beginning—like budgeting—will become second nature. The amount of attention you should have to devote should decline as your financial plan and persona evolve. Eventually, you won’t even need to write your budget down. It will simply become part of your financial persona operating in the back of your mind.

2 A Small Dose of

Personal Finance Math

Certain aspects of personal finance require understanding of a few very specific and highly applicable mathematical principles. You don’t need fluency in calculus or statistics to take control of your finances. Sure, you can run your own calculations, but there are also tools that can help you—the point is that you should be able to understand the principles behind the calculations. In this chapter, you’ll learn about taxes, inflation, and the time value of money, as well as a few easy ways to apply these principles.

Inflation: Depreciation of Currency

Inflation could be defined as the erosion in the purchase value of currency. Inflation renders each dollar (or whichever currency you use) less valuable—it purchases fewer goods and services than it did before. Does this affect your personal finances? It does, but not so much as you might think—if it is slow, steady, and predictable.

You don’t need to worry a great deal about inflation unless you have significant dollar assets, are counting heavily on future investment returns, or are concerned about future interest rates. But you should always keep inflation in mind when thinking about your finanacial future and be prepared to adjust your figures accordingly.

Inflation means prices go up over time. If you have long-term goals, such as college and retirement, that sounds ominous—what will that trip to Paris cost twenty years from now, anyway? What makes it less of a concern is that, as a wage earner, your wages—the price paid for your labor—should also go up to keep pace. Will you lose buying power? Unless you work for a government, nonprofit, or other concern that is forced to freeze wages due to hardship or publicity, you shouldn’t lose too much buying power. Where’s the problem, then? It is where you are relying on economic wealth or income supplied other than by wages. Here is where inflation affects you the most:

Money assets: If your assets are in the form of cash or are based on the dollar, you are exposed to declines in dollar value. If you had $10,000 in the bank, and next year’s inflation rate turned out to be 5 percent, at the end of next year you would have about $9,500 in equivalent purchasing power.

Return rate: If you are counting on an 8 percent growth in your asset base, and inflation is 3 percent, you must earn an 11 percent rate of return, in dollars, to achieve an 8 percent real growth. Otherwise, your wealth won’t buy you as much in the future as you were counting on. When projecting the growth of your assets, you must always adjust for inflation and keep in mind both a before inflation and an after inflation figure.

Interest rates: Interest rates are driven in part by inflation and in part by expectations of inflation. That is, if inflation is at 10 percent, a person lending you money would expect to get a real return on their money, plus an adjustment for the inflation that occurred while their precious dollars depreciated in your hands. So even the best interest rates at that time might be 14 or 15 percent. Does that affect your personal finances? You bet. You need to keep track of inflation, because that may tell you which way interest rates are heading.

Taxes—Here to Stay

You’ve heard it before. People think that if they get a raise, they’ll just lose that difference to taxes. Or they think they can spend more money because they can write it off. Those thoughts are true—to an extent. You will get those tax deductions from a mortgage and you will pay more taxes if you get a raise, but it’s not a one-to-one ratio. You don’t get taxed a dollar on every dollar earned, nor do you save a dollar of taxes on every dollar spent.

The trick is to always be aware of the residual left over after taxes are paid. And that’s where the formula (1 – t) comes in. This simple formula, where t equals the total marginal tax rate, allows you to figure out how much of your income will be left after income taxes. All you need to do is multiply the amount of money to be taxed by (1 – t) where t is the marginal (that is, highest applicable) tax rate.

Suppose the marginal tax rate (t) is 35 percent. What does that mean? Well, at that rate, for every new dollar you earn, you will lose 35 cents to taxes. Let’s say you get a $1,000 raise. To figure taxes on that amount of money at this tax rate, use the formula like so: 1 – .35 = .65; multiply .65 by the amount of your raise, $1,000, and you find that after taxes, you are only getting $650. Likewise, for every dollar you spend on a deductible expense, you will reduce your taxes by 35 cents, so if you spend $1,000 a month on deductible home-mortgage interest, the real cost of that mortgage to you is $650 a month.

Federal and State Taxes

How did we arrive at a total t of 35 percent? For a majority of readers, the federal marginal tax rate (as of 2002) is 27 percent; that is, every incremental taxable dollar is taxed to the tune of 27 cents. Many of you also have state and local income taxes, which would account for an additional 5 to 10 percent. You can figure your federal and state/local tax total like this. Let’s say your state/local tax rate is 10 percent. To figure your total tax rate, subtract 10 percent of the federal tax rate from the rate itself: 27 – 2.7 = 24.3. Add the state/local rate, and we arrive at a full t = 34.3 percent (24.3 + 10 = 34.3).

The Time Value of Money

Money has time value. A dollar in your possession today isn’t worth the same as a dollar you may get tomorrow, next month, next year, or twenty years from now. Why? First, the dollar you have today allows you to do something or buy something today. Right now. And for most of us, not having to wait translates to value. Secondly, as just explored, inflation will reduce the purchasing power of the future dollar.

A person lending us money to use today is giving up his/her right to use it today, and wants compensation for that. What do we call that? Interest. Interest is a time-based fee or price paid for the use of money. As time goes on, interest payments accumulate with an investment. At the end of that period of time, the interest accumulated represents the value received for time committed to the investment. A sum invested today will retrieve the original investment plus the interest accumulated at the end of the time period. If you need a sum of money twenty years from now, you need only invest a smaller sum of money today, and let the interest received build up to the desired twenty-year total.

Value—Present and Future

Suppose you have $1 today. You invest it at an annual rate of return (let’s say, from interest) of 10 percent. After one year, you will have $1.10 (original investment plus 10 percent of that investment). At the beginning of year two, the entire $1.10 is invested, still at 10 percent. So at the end of year two, you will have $1.21 ($1.10 + 10 percent of $1.10). And so forth. If you’re standing here at Day One looking forward, the original $1 is your present value, and the $1.21 is the future value at the end of two years.

The principle of compounding is one of the most important principles in both personal and business finance. Compounding was just illustrated: a sum of money $1 received a percentage return (10 percent) in the first year. The entire balance was left for another year, still at 10 percent, receiving the return not only on original principal but on last year’s interest, too. Each year’s golden eggs become part of the next year’s goose, which in turn lays still more golden eggs. And after a number of years and with a good rate of return or yield, that flock of geese can become quite large.

Bringing the Future Back to the Present

In the previous example, a present value of $1 was invested and allowed to compound into a future value of $1.21 in two years at a rate of 10 percent. But what if all we need is $1, two years from now? What if $1 is our down-the-road objective?

Simply, we need to calculate what amount of money, if invested today, would compound to $1 two years from now. That figure will be obviously less than $1 (it’ll be 82.6 cents, if you want to be exact).

Why would we need such a figure? Suppose we decide we need $500,000 to retire twenty years from now. What amount would we have to have today to reach that goal? It’s the same principle—what number, if invested at 10 percent (or whatever rate you want) would become half a million twenty years from now? For those wanting an answer, it is $74,500. Yes, a mere $74,500 invested at 10 percent for twenty years would indeed become half a million, without a dime additional being added. Is this interesting? You bet.